Fundamental Principles of Public Finance - BrainMass1.pdfCHAPTER 1 Fundamental Principles of Public Finance Why study public ﬁnancial administration separately from business ﬁnance?

CHAPTER 1

Fundamental Principles of Public Finance

Why study public financial administration separately from business finance? Mod-ern public financial administration liberally borrows the tools and concepts of busi-ness management. Financial management in business seeks to increase the value ofthe firm to its owners by judicious allocation and control of its resources. Public financial management uses similar analytic, technical, and managerial tools to allo-cate and control, but governments differ from private businesses in terms of re-source constraints, ownership, and objectives. In particular, governments may taxto enlarge their resources, “ownership” is not clear because many stakeholdersshare a legitimate interest in government decisions, and the value of governmentservices is neither easy to quantify nor reflected in a single measure (like the salesor profits of a business enterprise). And behind all these differences lies the uniquepower of government to tax, prohibit, and punish. This capacity to coerce, even indemocracies, makes governments different from proprietary businesses and volun-tary organizations; the reflection of those differences makes public financial admin-istration distinct from many fundamental practices of business finance. Both sortsof entities are interested in fiscal sustainability, that is, the ability to operate over thelong term without reducing the standards of life below those currently enjoyed andeven to improve that standard.

Many different organizations—private businesses, nonprofit organizations, andgovernmental agencies—provide the goods and services that we use every day, in-cluding both those necessary for life itself and those that make life more enjoyable.Private businesses sell us food and clothing, cars and television sets, and so on: avast range of commodities that we purchase for survival and enjoyment. The sameapplies to services: We go to movies run by private companies, travel across thecountry on privately operated airlines, and hire the neighbor to feed our cats whenwe go on vacation. All these and many more goods and services are provided undermarket principles of voluntary exchange: Businesses provide those services to us in exchange for the payment we make to them. No payment, no service. Much the same applies for many nonprofit organizations, like hospitals and social service

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organizations, that operate on the basis of charges and government contracts. Otherservices come from voluntary associations or clubs—the services of the county his-torical museum, the local neighborhood association, or a local youth organization.Their operations are financed by a variety of contributions and fees. Although mostvoluntary organizations do not require payment before service is rendered, they stillneed to be paid by someone, voluntarily, in order to survive, because those whoprovide the resources that are used in providing services (utilities, rents, supplies,etc.) need to be paid for those resources. Finally, we receive services of police de-partments, school systems, the judicial and regulatory systems, the social safety net,and so on, from governments. But these services are financed differently. Ratherthan operating from finance by voluntary exchange (market sales) or by voluntarycontribution, governments provide goods and services paid by taxes or other rev-enues raised by law. This revenue comes not from voluntary purchase or contribu-tion, but, even in a democracy, from the operation of a revenue system based onlegal requirement for payment, backed, if necessary, by force or threat of force.That is coercion, something we dislike and distrust. In our open and free society,why have a public sector? The reason is that government services are uniquely es-sential to life: Most countries leave the provision of life’s necessities—food, cloth-ing, and usually shelter—to the private sector. But when government fails, the pri-vate sector cannot function and citizens are “bereft of even the most basicconditions of a stable existence: law and security, trust in contracts, and a soundmedium of exchange.”1 Without a government that does its job in at least somebasic areas, the private sector itself cannot properly function.

2 Chapter One: Fundamental Principles of Public Finance

1International Bank for Reconstruction and Development/The World Bank, World Development Report1997, The State in a Changing World (New York: Oxford University Press, 1997), 19.2Economic Report of the President Transmitted to the Congress February 1997 (Washington: U.S. GovernmentPrinting Office, 1997), 191.

Market Failure and the Functions of Government

Why can’t private businesses selling their products in free markets be relied upon toprovide all goods and services that ought to be available? The argument for the effi-ciency of markets is powerful. The President’s Council of Economic Advisors ex-plains: “If markets are competitive and function smoothly, they will lead to pricesat which the amount sellers want to supply equals the amount buyers demand.Moreover, the price in any market will simultaneously equal the benefit that buyersget from the last unit consumed (the marginal benefit) and the cost of producing thelast unit supplied (the marginal cost). These two conditions ensure efficiency: whenthey hold in all markets, the Nation’s labor and other resources are allocated to pro-ducing a particular good or service if and only if consumers would not be willing topay more to have those resources employed elsewhere.”2 Markets cause the pro-ductive capacity of the economy to be used to produce what people want most and

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cause the least possible amount of resources to be used in that production. In aworld of limited resources, it is a valuable result.

But there remains an important role for government, even if private marketscan deliver most goods and services, and deliver them at low cost. Indeed, there isan important cooperative relationship between healthy government and healthymarkets. Markets need government to function efficiently: “Deals must be enforcedand fraud discouraged. Without a governmental legal system to guarantee propertyrights and enforce contracts, corporate organizations and market exchange wouldbe virtually impossible. Anarchy and the free market are not synonymous.”3 Gov-ernment—at least its protective elements—is necessary if markets are to exist. Andgovernments can obtain important information from market data, use markets asefficient mechanisms for implementing public policy, and acquire goods and ser-vices in market transactions to provide government services. The market economyneeds government to function properly, and governments need the market econ-omy if they are to serve the public interest.

The role of government, however, extends beyond simply allowing markets tooperate, because a system of markets is not always able “to sustain ‘desirable’ ac-tivities or to stop ‘undesirable’ activities.”4 What makes some services a govern-mental responsibility? Why can’t private action be relied upon to provide policeand urban fire protection, primary education, environmental protection, publichealth, national defense, and so on? Individuals demand these services, and we ex-pect businesses to respond to customer demand in their quest for profit. Why domarkets fail, and thereby create an economic need for government?

Public Goods5

Some goods will not be supplied in the market or, if supplied, will be supplied ininsufficient amounts because of their very nature. The problem comes from twoproperties: (1) nonexhaustion, or nonrivalry, occurs when benefits of the servicecan only be shared, meaning that a given quantity of the service can be enjoyed byadditional people with no reduction in benefit to the existing population, and (2) in-ability to exclude nonpayers occurs when benefits cannot be easily limited to thosewho have paid for the services. The properties reflected in Figure 1–1 distinguishprivate goods, public goods, and two intermediate kinds of goods—toll goods andcommon-pool goods.

Chapter 1: Fundamental Principles of Public Finance 3

3Ibid., 192.4Francis M. Bator, “The Anatomy of Market Failure,” Quarterly Journal of Economics 72 (August 1958): 351.Public goods are only one type of market failure, but they form the basis for budgeting, taxation, andother parts of fiscal administration. Other failures create the need for government regulation of monopo-lies; these failures are not considered here.5Some argue that individuals do not recognize their own best interest and that market evaluations madeby individuals may be “wrong.” In other words, the market underprovides museums, ballets, and sym-phonies because people do not understand their true value. Therefore, it is argued that these institutionsdeserve support as merit goods. (Junk food, Saturday morning kids’ television, and country music couldbe viewed as merit bads.) Identifying what is good and what is bad is certainly not scientific (you maydisagree with the examples listed here) and ends up in special-interest political battles.

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What do these public-good properties mean? When services are nonrival, useof the service by one person does not preclude concurrent full use by others at noadditional cost of providing that service. The cost of providing service to additionalusers, once the service has been provided for someone, equals zero (its marginalcost is zero). Economic efficiency requires that the price paid by the buyer (thevalue of resources given up by the buyer to make the purchase) not exceed the ad-ditional cost of producing the purchased good or service. A private business willcharge a price higher than zero, the efficient price, because it cannot afford to dootherwise. Therefore, too little of the good or service will be purchased and con-sumed, and its price will be too high, compared with quantities and prices in a fullyfunctioning market. When exclusion of those who have not paid for the service isnot feasible, a seller could not successfully charge a price; people not paying wouldreceive the service as completely as those who paid. Private goods do not have ap-propriability problems: One person’s use of the good eliminates the possibility ofanyone else using it (additional service means extra cost, and sellers charge to coverthat cost), and exclusion is feasible. Obviously, the full range of ordinary commodi-ties and services (bread, milk, etc.) are private goods. The only way an individualcan receive the benefits from a private good is by paying for it; there are no effectson others, and it is possible to separate payers from nonpayers.

Public goods include national defense, mosquito abatement, pollution control,and disease control. The common characteristics of these services are (1) once theyare made available, denial to those who have not paid is impossible (nonexclusion),and (2) any number of people can consume the same good at the same time with-out diminishing the amount of that good available for anyone else to consume(nonexhaustion, or nonrivalry). Consider mosquito abatement. When a given levelof control is provided, all people in the area of control receive the same service.Other people could enter the control district and receive that same service without


Figure 1–1The Elements of Nonappropriability

Exhaustion or Rivalry

Alternate Use Joint Use

Private Goods Toll Goods

Feasible Examples: Food, Examples: Turnpikes,clothing, television sets toll bridges, motion

picturesExclusion

Common-Pool Resources Public Goods

Not feasible Examples: Aquifers, Examples: Nationalfishing grounds, defense, system of petroleum reserves justice, vector control

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any additional abatement cost. Many people can simultaneously consume that ser-vice, once it has been provided, without diminishing the amount of service avail-able to others (the marginal cost of service is zero), and there is no mechanism todeny service to those not paying for it. Individuals in the service area may value theabatement service differently (reaction to mosquito bites varies among individuals),but all receive the same level of service. This is completely different from the situa-tion with a private good, like a hamburger: When you eat that burger, it is gone andnot available for consumption by anyone else—no nonrivalry.

The failure of exclusion is the other public-good characteristic. Within therange of exclusion failure, if someone provides the services, all receive that service.When one structure in an urban area receives fire protection, given the propensityof fires to spread, nearby structures receive protection as well.6 (The public good isfire protection, not fire fighting; when the equipment is putting out the fire atSmith’s house, it is not available to put out the fire anywhere else. ExtinguishingSmith’s fire, however, provides fire protection equally to many neighbors.) Obvi-ously, there are geographic limits to that range of nonappropriability: Fire protec-tion provided in Bloomington, Indiana, will not extend to the people in Jackson,Mississippi. Within a specific geographic area, however, all receive the service re-gardless of payment, whether they want it or not. Such is the special monopoly po-sition of governments: Not only are alternative providers unavailable, but residentsalso do not have the option of not paying for the service because public revenuesystems operate independently from service delivery. A governor of Kentucky rec-ognized the difference between operating the state and operating his successfulbusiness: “Hell, governing Kentucky is easier than running Kentucky Fried Chicken.There’s no competition.”7 Payment regardless of preference or consumption is, ofcourse, a unique feature of government provision.

Toll goods and common-pool goods have one public-good characteristic butnot both (as shown in Figure 1–1). Toll goods are nonrival: One person can con-sume the service to its fullest while not reducing the amount of service someoneelse may consume. For these goods, however, exclusion is feasible; boundaries canseparate payers and nonpayers. Examples include drive-in movies and toll roads:Up to a congestion point, a larger number of people can consume these serviceswithout exhausting the service concurrently available to others.

Common-pool goods are goods or services for which exclusion is not feasible,but there are competing and exhaustive uses. Examples include aquifers, oil and gasdeposits, and fisheries. There are no normal means of exercising exclusive propertyrights on the resource, but when used, the resource becomes unavailable for others.Left to private processes, the resource may be rapidly exhausted because it is valu-able and is not, in its natural state, subject to normal ownership controls. (First-come-first-served is a normal allocation principle, so getting those resources out of


6Private firms sell fire protection to individuals in some parts of Arizona. Neighbors are distant and firesseldom spread over desert land, so the service is a private good. Roger S. Ahlbrandt, Jr., Municipal FireProtection Services: Comparison of Alternative Organization Forms (Newbury Park, Calif., and London: SageProfessional Papers in Administration and Policy Studies 03-002, 1973).7The Honorable John Y. Brown, Jr., quoted in Newsweek (March 30, 1981).

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the ground as quickly as possible is advantageous to any private user—and is whygovernments frequently intervene in markets for natural resources. That is anotherelement of market failure.) Sidebar 1–1 describes one common-pool resource prob-lem and how government action sought to remedy it.

Externalities

Market transactions between buyer and seller may affect third parties. The conse-quences may be negative—as with the exhaust fumes from automobiles—or posi-tive—as with the protection provided pregnant women when a boy receives arubella vaccination—but, either way, that value is unlikely to be fully recognized inthe market transaction. For these goods and services, the private return from theirconsumption is substantial, so the market will not fail to provide. It will not, how-ever, provide at a socially reasonable level.

An attractive (or positive) externality causes the good in question to be under-produced. In the case of the rubella vaccination, those people who are vaccinatedreceive the benefit of reduced probability that they will contract the disease, a di-rect benefit to them for which they could be expected to pay. But they also provideprotection against the disease to others in that they will not infect others if theythemselves do not have the disease. That is a third-party, or external, effect of thevaccination. It is unlikely that everyone considering the vaccination will take full ac-count of these benefits when weighing the advantages of vaccination against the dis-advantages (minimal discomfort and some small risk of adverse reaction, time spentand inconvenience met in receiving the injection, and the out-of-pocket price of theservice), and some will decide not to be vaccinated. Fewer people would be vacci-nated than would be in the best economic interests of society, because of the ex-ternal benefits from the personal choice about vaccination. Governments requireyoung boys to get rubella vaccinations not simply to protect them—rubella itself isnot much worse than a common cold—but because we do not want them to givethe disease to a pregnant woman and cause birth defects in her child.8

An undesirable (or negative) externality has the opposite effect, an overproduc-tion of the good. Automobile operators choose to pay the operating costs of theircars to enjoy the great personal value of mobility that cars provide, without full at-tention to the undesirable health and esthetic effects of the exhaust fumes pro-duced by their vehicles or of the congestion delays caused by having many vehiclescompeting for highway space. Again, this leads to a misallocation of resources:


8Public health officials refer to the concept of “herd immunity:” if enough of a population is immunizedagainst an infectious disease, even those without immunization will be protected because any invadinggerm will not be able to spread. There is no chain of transmission. When the “herd” is sufficiently immu-nized, those without immunization are able to enjoy free-rider protection. But if overall immunizationlevels fall below a critical threshold percentage of the population, that protection is gone. Hence, publichealth officials work to maintain immunization levels even when prevailing incidence of the disease islow, because protection of that “herd immunity” that provides protection for all.

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Sidebar 1–1Government Creates a Market for Fishing Rights

Market failure does not always require direct government provision of a service as a remedy.Sometimes, the government may intervene in ways that create a market where none couldexist before. The Council of Economic Advisors provided one example in the Economic Report ofthe President for 1993:

There is no practical way to establish ownership rights of ocean fish stocks. Traditionally, fishhave been free for the taking—a common pool resource. Theory teaches that such underpricingleads to overconsumption. In the halibut fisheries off Alaska, fishing fleets caught so many hal-ibut that the survival of the stock was threatened. No single fishing boat had an incentive toharvest fewer fish since the impact on its own future catch would be minimal and otherswould only increase their take. This is an example of what is known as “the tragedy of thecommons.”

Officials tried limiting the length of the fishing season. But this effort only encouraged new cap-ital investment such as larger and faster boats with more effective (and expensive) fishingequipment. In order to control the number of fish caught, the season was shortened in someareas from 4 months to 2 days by the early 1990s. Most of the halibut caught had to be frozenrather than marketed fresh, and halibut caught out of season had to be discarded.

In late 1992, the federal government proposed a new approach: assigning each fisherman a per-mit to catch a certain number of fish. The total number of fish for which permits are issued willreflect scientific estimates of the number of fish that can be caught without endangering thesurvival of the species. Also, the permits will be transferable—they can be bought and sold. Bymaking the permits transferable, the system in effect creates a market where one did not existpreviously. The proposed system will encourage the most profitable and efficient boats to oper-ate at full capacity by buying permits from less successful boats, ensuring a fishing fleet thatuses labor and equipment efficiently. Moreover, the transferable permits system establishes amarket price for the opportunity to fish—a price that better reflects the true social cost of usingthis common resource.

The cap-and-trade system for dealing with environmental protection applies a similar ap-proach. Sources of emissions (like sulfur dioxide) are allocated an initial emissions limitation.The entity is permitted to meet the limit by whatever means it chooses (conservation, revisedproduction technology, end-of-pipe controls, etc.), so each will select whatever method is leastexpensive. But the entity can exceed its limit by purchasing limit caps from other entities—those who have excess cap because of particularly efficient methods for limiting their emis-sions. By this means, the intended overall emission reduction is achieved at minimal cost to theeconomy. The market price for emission limits emerges, exactly in the same way as the pricefor the opportunity to fish was established.

Both are clever ways to employ market-based approaches to deal with problems of initial mar-ket failure and achieve an efficient, effective, and low-cost solution.

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more car miles traveled than would be the case if their operators based theirchoices on the full social cost (internal plus external) of using the car.

Governments regularly subsidize or tax to try to correct these market failurescaused by externalities.9 For instance, governments may pay producers or con-sumers of goods with positive externalities to encourage more consumption of thegood in recognition of benefits to third parties. They may also levy corrective taxesto make purchasers and sellers respond to the external damage done by other prod-ucts. The idea is to make buyers and sellers respond to the external effects of theproduct, to bring the third-party effect into their decision-making in an economi-cally tangible way.

Failure of Competition

The efficiencies of markets arise from competition among firms. When only a fewfirms serve a market, those firms may exercise monopoly power to charge priceshigher than justified by economic conditions and, thereby, to collect excess profits.Governments watch markets to ensure that barriers do not prevent new firms fromentering such markets, because entry of new firms in the industry is the best deter-rent to monopoly pricing. And governments strictly police practices that unfairlyrestrain trade. Sometimes governments choose to regulate industries that, becauseof cost advantage to larger firms (or increasing returns to scale), seem destined to bedominated by a few large firms (the natural monopoly case). This may be the situa-tion for electrical, telephone, water, and some other utilities, although new tech-nologies (e.g., lower production cost for alternative electricity generators with smallproduction capacity, and diverse telecommunication systems) have opened newcompetitive options in many such industries. As this occurs, governments haverightly moved from strategies of legalistic regulation of firm operations and theprices they charge to removing barriers to the entry of new firms, thereby allowingcompetition to allocate resources and establish reasonable prices for products. Nev-ertheless, expecting private businesses to regulate failures of competition—withoutthe government’s prompting—is not reasonable.

Incomplete Markets and Imperfect Information. Governments often inter-vene in markets when customers have incomplete information about products andthere is fear that unfettered market forces will not provide necessary information ina timely fashion. Governments test (or supervise the testing of) new drugs, guardagainst the sale of hazardous products, establish certain disclosure standards, andso forth. The market may ultimately provide information—but not until after muchgrief and suffering by the unwary.

Insurance markets can present special problems of adverse selection and moralhazard. Adverse selection occurs when insurance purchasers impose higher-than-


9When transaction costs are negligible, bargaining between users of resources can internalize external ef-fects and cause an efficient level of output with no more government action (i.e., no taxes, no subsidies,and no prohibitions) than to establish private rights to the use of resources. Ronald Coase, “The Problemof Social Cost,” Journal of Law and Economics 3 (October 1960): 1–44.

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average costs on sellers (in health insurance, for instance, those more likely to pur-chase insurance are those more likely to need care) or when sellers exclude such po-tential purchasers (health insurance companies seek to exclude those more likely torequire care). It is a particular problem for provision of private prescription drug in-surance (or the voluntary Medicare prescription drug benefit program): people varywidely in the extent to which they have high drug expenses, and both high- andlow-expense people generally know into which group they fall. The only takers ofa plan with premiums that reflect average prescription expenses would be thosewith high expenses, and, hence, the finances of the plan would be doomed. Insur-ance sellers rely on having both sets of people in the premium pool. Moral hazard isa problem when those with insurance have an incentive to cause the insured eventto happen or to be less than diligent in averting the insured event. For example,with health insurance, there is a tendency for people to seek more treatment whenthe third party, the insurance company, is paying for it.10 In a case of governmentfailure, federally subsidized flood insurance (premiums for the federal NationalFlood Insurance Program represent only about 38% of what a full premium wouldbe) makes people more willing to build in floodplains and in coastal areas, thus in-creasing the loss when the inevitable flood occurs, as with Hurricane Katrina in2005; and federal bank deposit insurance with coverage to high deposit levelsmakes people less interested in considering the financial strength of the institutionsholding their deposits. Reasoned government intervention involves securing wide-spread coverage (to prevent adverse selection) and regulating markets to ensure thatdecision-makers see the accurate cost implications of those choices. Social insur-ance systems (public pension, health and disability, unemployment, etc.) through-out the world stem from these market problems.11

Economic Stabilization. Governments seek to stabilize the macroeconomy,in other words, preventing high unemployment, controlling inflation that coulderode purchasing power and distort financial markets, and improving the prospectsfor economic growth and a higher quality of life. Governments use monetary pol-icy (manipulation of the money supply) and fiscal policies (changes in expenditureand taxation) to correct for these aggregate failures of the market, although there iscontinuing controversy about the extent to which those policies can make an activeimprovement in performance. Nevertheless, evidence does indicate that poor gov-ernment decisions in use of national resources and financing of government pro-grams in a misguided fashion can cause severe economic problems. Central govern-ments worry about the condition of the national economy, whereas subnationalunits (states, regions, cities, etc.) seek to improve their own particular share of thatnational economy. And some governments attempt industrial policy, targeted sub-sidies and tax advantages designed to stimulate particular industries, in the belief


10Another illustration of moral hazard: There is some evidence that making private automobiles saferhas encouraged drivers to be less cautious in their driving.11Another moral hazard: pitchers in the American League do not bat, so they do not face direct retalia-tion in the batter’s box and are thus more likely to throw at opposing batters than are their counterpartsin the National League, who do have to bat for themselves. J. C. Bradbury and D. J. Drinen, 2004. Identi-fying moral hazard: A natural experiment in Major League Baseball. Unpublished manuscript, The University of the South, Sewanee, TN. (Available online at: ddrinen.sewanee.edu/Plunk/dhpaper.pdf)

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that they can increase economic growth and reduce unemployment by giving anextra boost to activities destined to be national or even global leaders. Again, thecapacity of politicians and government bureaucrats to pick winners better than canmarkets is decidedly mixed, but that does not stop them from trying as theyarrange the public finances. There is also not much evidence to support the ideathat subnational government use of targeted tax and expenditure programs canhave much of an effect on economic development, but that does not stop the politi-cal leaders from trying. The Economist succinctly explains why industrial and eco-nomic development policy, whether national, state, or local, has such a low successrate: “Neither economists nor emperors can be relied upon to pick winners. Thebest bet is entrepreneurial trial and error.”12 Government money spent to assist par-ticular industries is, sadly, often badly spent, because even the well-advised govern-ment usually guesses wrong. If lawmakers really knew how to do this, would therebe poverty anywhere?

Redistribution. Markets distribute products of the economy to those peoplehaving resources (talents, properties, etc.), not distinguishing whether those re-sources were earned, inherited, stolen, or whatever. Those who own the resourcesget the goods. People with few resources—property or skills—may fall below ac-ceptable living standards and may be destined to a life of poverty in a pure marketeconomy. Governments may correct injustices in the distribution of affluence in so-ciety, seeking to improve the conditions faced by the less well-to-do that the mar-ket alone would leave them with. Some argue for a degree of redistribution out of asocial conscience and a desire for a safety net for all humanity; others argue for adegree of redistribution out of a fear that the poor will revolt, taking property fromthe affluent. Regardless of motives, most politicians believe that the public wantssome protection for the very poor and at least some mild redistribution by the gov-ernment of the result produced by pure operation of the market. Those concernsare reflected both in government spending programs and in systems for finance ofthose programs.

Governments employ a variety of different approaches toward redistribution.These include tax structures that levy relatively higher tax burdens on high-affluence households than on low-affluence ones (income taxes that levy higher ef-fective rates on high-income households), direct income payments to low-affluencefamilies (the earned income tax credit), programs that provide assistance servicesfor which only low-affluence families qualify (Medicaid), or programs available toall that low-income families use more heavily (unemployment benefit programs).However, the United States makes less aggressive use of active tax and transferprograms to handle problems of poverty than do other wealthy nations, preferringprograms of economic expansion that benefit everyone, trusting that economic ex-pansion will take care of the economic bottom as it benefits the economic top. As aresult, the gap between highest and lowest incomes and the level of poverty in theUnited States is considerably wider than in other wealthy nations.


12“Finding Your Niche,” Economist, 21 March 2003: 70.

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Modern societies argue about where to draw the line between government provi-sion and market provision of goods and services. Many governments have down-sized the public sector to achieve efficiency, in the belief that market provision mayoffer more service options to the public, more flexibility in service response, andlower operating costs. With those possible advantages, it is no surprise that privati-zation of government operations is an attractive option. After considering the ap-propriate functions of government, as we did in the last section, it is also reasonableto explore the range for which various forms of privatization may be reasonable.

Privatization encompasses (1) transfer to the private sector of government-owned businesses that operate in goods and services markets that do not have sig-nificant market failures, (2) transfer to the private sector of government-ownedbusinesses with natural monopoly power, especially telecommunications and elec-tricity, and (3) contracting out of publicly financed services to private businesses,using service contracts or franchise agreements.13 This latter variety of privatizationis possibly amenable to pure public goods; the former two may be accompanied bygovernment regulation of prices, returns, or other conditions of operation.

Arguments Supporting Privatization. Several logical arguments have beenoffered in support of privatization.14 These are three of the most frequently used:

1. Smaller government. Some argue for a smaller public sector and fewerpublic bureaucrats, resulting in a shrunken scope of government, largely as amatter of philosophy. Because governments may spend without producing ser-vices (e.g., the check writing of the American Social Security system) and maybe deeply involved in the private economy without even spending (e.g., thesafety regulations applied to private industry), privatization, while reducinggovernment production, may or may not reduce the size of government orstate involvement in the economy. This therefore provides a weak basis for pri-vatization.2. Operating efficiency and response to clients. Governments produceunder the political-bureaucratic system of central command and control, oftendriven from a desire to employ people with minimal attention to the need to atleast cover costs of operation. State enterprises frequently lack a hard budget


Privatization

13An excellent analysis of the economics of privatization is John Vickers and George Yarrow, “EconomicPerspectives on Privatization,” Journal of Economic Perspectives 5 (Spring 1991): 111–32.14A recent study of American local government ownership and management of enterprises (gas, electric,and water utilities and public transport) finds that a desire to stem corruption was a major influence innineteenth-century decisions to make ownership public. Reformers believed that managers of public or-ganizations would have weaker incentives to capture profits for the enterprise from corrupt activitiesand to risk prison for profits not personally received. The study also suggests that public ownership islikely to create inefficient operation and excessively high government payrolls. (Edward L. Glaeser,“Public Ownership in the American City,” National Bureau of Economic Research Working Paper 8613, De-cember 2001.) The anti-corruption argument may have continued applicability in privatization discus-sions in the developing and transition environment, but it is not a clear call.

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constraint and, when they operate at a loss, receive a government subsidy tocover it. This situation blunts any incentive for efficient operations. To survive,private businesses must respond to direct customer demand and must constrainprices out of concern for competition from other businesses. That environmentdrives private business toward operating efficiency (lower production cost) andimproved responsiveness to customers, but only if the new private businessesface a competitive business environment. There is no reason to believe that aprivate monopolist city water company would be more efficient and respon-sive than a government monopolist city water company serving the same terri-tory under the same regulatory conditions. The cost reduction associated withimproved operating efficiency is a frequent objective of government privati-zations in the United States. However, a number of studies have found theVeterans Health Administration hospital system to be a better performer thanthe systems available to other Americans.15 It is not always the case that a pri-vate system will outperform a government one—provided the incentives, direc-tion, and will are strong.3. Cash. Sale of government-operated enterprises may bring revenue to thegovernment. The inflow, assuming a buyer can be found, would occur at sale.Operating profits (or losses) in the future would disappear, although the enter-prise would then be subject to the tax system. Unfortunately, many govern-ment assets produce no revenue or produce revenue that is less than operatingcost. That makes their value extremely low. This is a problem that countries ofthe former Soviet Union have had to face as they try to move into a marketeconomy. Many state enterprises have high production costs and, even withprivate ownership, the product will not sell on national or international mar-kets at a price sufficient to cover those costs. Although the old central plans in-vested heavily in these plants, their privatized value has proved to be low—except in natural resource sectors (oil, gas, etc.). In other environments, the revenues have proved substantial. The cumulative total has been estimated atover $1 trillion through the second part of 1999; the annual flow of privatiza-tion proceeds has exceeded $100 billion in the last part of the 1990s.16

Other motives behind privatization include lack of appropriate personnel or ex-pertise to perform the service, provide greater operating flexibility, quicken imple-mentation of the program, increase the pace of innovation, and improve quality ofservice. However, it is important to understand that all government services are notequally susceptible to outsourcing and not all motives will be satisfied in any partic-ular privatization program.

The largest transactions involve formerly nationalized industries under old con-cepts of the economic role of government or of the need to keep “socially or eco-


15A number of studies are cited in Phillip Longman, “The Best Care Anywhere,” Washington Monthly, Jan-uary/February 2005. With other incentives, the public sector compares badly: Jishnu Das and JeffreyHammer, “Money for Nothing: The Dire Straits of Medical Practice in Delhi, India,” World Bank PolicyResearch Working Paper 3669, July 2005.16William L. Megginson and Jeffry M. Netter, “From State to Market: A Study of Empirical Studies of Privatization,” Journal of Economic Literature 39 ( June 2001): 321–89.

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nomically significant” industries under state control: telecommunications, petro-leum and petrochemicals, gas distribution, automobile manufacturing, electricitygeneration and distribution, airlines, steel making, and so on.17 Between 1990 and2000, 36 percent of privatization proceeds came from telecommunications, 16 per-cent from power, 15 percent from financial institutions, 10 percent from oil and gas,and 17 percent from other industries.18 Government operation of these industrieshas been notoriously bad because of political influences on service decisions (e.g., acity gets served by the national airline because an important politician lives there)and on operations (e.g., the industry is seen as employer of last resort and the re-sulting bloated payrolls prevent it from ever producing its product at a competitivecost).19 Governments in the United States have been less active in recent privati-zation than those in Western Europe, Latin America, Asia, New Zealand, and Australia. Many of the big international privatizations, however, have been in in-dustries never publicly owned in the United States. Privatization of roads, airports,the postal system, schools, and the like raise much more interesting social, political,and economic issues than the state sale of telephone or petrochemical companies.20

Production/Provision. The American privatization issue frequently concernsthe provision-production dichotomy.21 Goods and services provided by a govern-ment because of market failure need not be produced by that government. Provisionmeans government intervention to ensure availability or, generally, to finance theservice; it does not require production by the government. The production choiceshould be made according to which entity—a government department, a private en-tity (profit or nonprofit), or another government—would supply the desired quan-tity and quality of service at least cost to the citizens of the providing government.

The distinction between government and private production and provision canbe clarified by example:

1. Government provision/government production. The city street depart-ment plows the streets after a heavy snowfall. The job uses department man-agers, department employees, department equipment, and department supplies.2. Government provision/private production. The county hires a privateappraisal firm to estimate values of real estate in the county for use in computing


17The largest of all was the sale of Nippon Telegraph and Telephone by the government of Japan. Shareofferings in 1987 and 1988 raised almost $80 billion; the $40 billion offering in November 1987 is thelargest security offering in history.18William L. Megginson, The Financial Economics of Privatization (New York: Oxford University Press,2005): 27–28.19National airlines can face difficult political barriers to efficient operations. Keith Johnson and Luca DiLeo, “Alitalia Can’t Stanch Red Ink,” Wall Street Journal (April 21, 2004): A-16. Difficult staff reductionsthen being proposed would have brought Alitalia down to about 1,100 passengers per employee. Thatcompared with about 9,000 passengers per employee for the competing discount carrier Ryanair.20The pioneer of privatization in the last decades of the twentieth century, Britain, has been unable tofully privatize its coal industry, so apparently technically simple decisions do get muddled by politicsand other factors.21It also encompasses application of user-pay concepts, including sale of service and tax payments basedon the benefits received from particular government services. These mechanisms, while bringing somemarket-like principles, do not alter public provision and thus are discussed in the revenue section of thisbook.

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property tax bills. The firm does the work with its managers, employers,equipment, and supplies. Another example: The U.S. Department of Defensehires private firms to provide food and other support services to military unitsin the field. Outsourcing is almost certainly the most common privatizationpracticed in the United States.22 It is a major element in President Bush’s man-agement agenda for the federal government, which intends competitive sourc-ing for federal tasks that are readily available in the commercial marketplace.23

3. Private provision/government production. A racetrack pays a city for ex-traordinary traffic control services on race days.4. Private provision/private production. A private manufacturer patrols itsfactory site with its own security employees.24 Neighboring properties may re-ceive some protection spillover from this security activity.

Some cities, especially in California, have provided a full range of services en-tirely by contract. Such an arrangement is called the Lakewood Plan after an earlycontract city.25 Production by contract is probably limited more than anything elseby the ability to design a contract specifying the service qualities to be delivered.Even parts of the judicial system may be privately produced: California permits liti-gants to hire private jurists when court congestion or special expertise makes such aprocedure attractive to both parties, and private firms have undertaken contractualoperation of correction facilities.26 School districts have similarly chosen privateproduction through vouchers or charter schools.27 In these systems, the school dis-trict provides financing but the educational service is actually produced by anotherentity.

The production choice should be kept open for possible privatization; the ideaof government action is to provide services of desired quantity and quality at theleast cost to the economy. When might contracting not be an efficient option? Onestudy suggests that in-house production may be warranted when “(1) there are veryfew potential suppliers, (2) costs of switching from one producer to another arehigh, (3) information about the production process and supplier performance is


22U.S. General Accounting Office, Privatization: Lessons Learned by State and Local Governments,GAO/GGD-97-48 (Washington: U.S. Government Printing Office, 1997).23The efforts by the Bush administration to outsource government operations is described in JohnMaggs, “Compete, or Else,” National Journal ( July 12, 2003): 2228–2237.24Businesses and individuals in the United States spend over twice as much for private security as gov-ernments spend on providing public safety. “Welcome to the New World of Private Security,” Economist(April 19, 1997): 21.25Robert Bish, The Public Economy of Metropolitan Areas (Chicago: Markham, 1971), 85.26“California Is Allowing Its Wealthy Litigants to Hire Private Jurists,” The Wall Street Journal(August 6, 1980); and U.S. General Accounting Office, Private and Public Prisons: Studies ComparingOperational Costs and/or Quality of Service, GAO/GGD-96-158 (Washington: U.S. Government Print-ing Office, 1996). Correction facilities face an interesting incentive problem: it is against their economicinterests to rehabilitate criminals in their care because successful rehabilitation reduces demand for theirincarceration services.27Gary Putka, “Baltimore Test of Privatization Gets a Bad Start,” Wall Street Journal (September 23, 1992).Voucher systems provide families an education grant—a subsidy for purchase of education—which maybe spent on services from a variety of producers. Charter schools allow private entities to create schoolsoutside the public system, with finance from public funds. Families pick among schools.

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expensive to obtain, and (4) the good or service being provided cannot be clearly de-fined.”28 In other words, the option would be difficult if contracts would be espe-cially difficult to write and the public would end up being confronted with a monop-oly supplier. Otherwise, out-of-government production can be an efficient option.

Privatization of provision is a more difficult problem. For public goods, themarket will not function because the private supplier will not charge an efficientprice for the service because of nonrivalry and inability to exclude. Business firmsprovide goods and services because they intend to make money, not for the sheerenjoyment of providing the goods or services. If it is not possible to charge peoplefor the good or service, a business firm will seldom provide it. Furthermore, theprice will exceed the cost of providing service to an additional consumer (recall thatthe additional cost is zero).

The expectation of government provision of public goods is strong, but occa-sionally governments will provide private goods as well and often do a very bad jobof it. Organizational problems, particularly lack of appropriate production incen-tives, cause high costs, undesirable production strategies, and a bland product de-signed by an uneasy consensus. Governments provide toll goods (highways, bridges,etc.), and sometimes they do about as well as the private producer would do. Buteven some toll goods are provided by private businesses. For instance, in France eightpublic/private joint ventures and one private company operate the toll highway/tunnel system, the most extensive auto toll system in Europe. Evidence indicates thatfewer resources will be wasted if government avoids provision of private goods.

Some observers of public fiscal problems have suggested that privatizationwould relieve pressures on government finances. That is a realistic response if theservice being privatized in fact lacks substantial public-good features; one wonderswhy, in such a case, the government got involved in its provision. On the otherhand, to expect private firms to provide public goods at desirable levels is folly. Atbest, the private firm may be contracted to produce the public good provided (paidfor) by the government.

Privatization cannot be a general and complete cure for fiscal problems, nomatter how inefficient a troubled government might be. For public goods, efficientprivate provision cannot substitute for inefficient government provision of publicgoods. That does not mean that market incentives cannot help, however, in guidingprovision by government.

Building Social Decisions from Private Preferences

The logic of moving from individual choice to choices made by society is built on three fairly simple tenets. First, individuals are the best judges of their own well-being and generally act to improve that well-being as they see it. There is no


28John C. Hilke, Competition in Government-Financed Services (New York: Quorum Books, 1992), 8. Whydoes the federal government run its own printing house, the Government Printing Office? To learn moreabout mixed motives, see Graeme Browning, “Stop the Presses?” National Journal 25 (October 16, 1993):2483–85.

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scientific principle that leads us to reject or accept the judgments made by individu-als about their own lives. Dictators or philosopher-kings may accurately makethose determinations, but others should not assume that responsibility. Second, thewelfare of the community depends on the welfare of the individuals in that com-munity. In other words, communities are made up of people, and community wel-fare increases only if the welfare of those in the community is improved. From thatcomes the third tenet, judging the impact of a social action on the welfare of thecommunity. The Pareto criterion, named after a nineteenth-century economist,holds that if at least one person is better off from a policy action and no person isworse off, then the community as a whole is unambiguously better off for the pol-icy.29 Does a social action harming anyone, despite improving the condition ofmany individuals, improve the welfare of society as a whole? It cannot be indis-putably argued that such an action improves the well-being of society, regardless ofthe numbers made better off, because the relative worth of those harmed cannotscientifically be compared with those helped. Such a proposed policy would fail thePareto criterion for judging social action.30

With those standards, we can analyze the implications of nonappropriabilityon public provision. Suppose that only five people would be influenced by con-struction of a levee to protect a small area from periodic flooding of a river. Thecost of that levee is $20,000. Each individual in this community knows the maxi-mum sacrifice that he or she would be willing to make to have that levee as com-pared to having no levee at all. Presumably it would not be larger than the individ-ual damage avoided by having levee protection. These are the individual benefitnumbers in Table 1–1. The levee, we assume, would be a public good: Each indi-vidual could use it without diminishing its availability to anyone else in the com-munity, and exclusion of nonpayers is not feasible.

First, would the levee be built without public action, that is, by individual ac-tion only? The cost of the levee is $20,000; the most that any single individual (in-dividual D) will pay to get the levee built is $9,000. Thus, the levee would not beproduced by any single individual. If the levee only cost $8,500 to construct, how-ever, we suspect individual D would build the levee for his or her benefit, and fourother people in the community would receive benefits from the levee without pay-ment. (The four would be free riders.) Once the levee is there, it serves all because ofits public-good features.31 The initially presumed construction cost, however, issuch that the maximum individual benefit is less than the cost of the project, so thelevee will not be built by private action.

Is the levee economically desirable for the community, in the sense that thevalue of the levee is greater than the resources going into the construction of the


29Vilfredo Pareto, Manuel d’Economie Politique, 2d ed. (Paris: M. Giard, 1927), 617–18.30Benefit-cost analysis, an analytic technique that will be discussed in a later chapter, employs a less re-stricting and somewhat less appealing rule than the Pareto criterion. This is the Kaldor criterion, whichholds that a social action improves community welfare if those benefiting from a social action could hy-pothetically compensate the losers in full and still have gain left over. Because no compensation need ac-tually occur, losers can remain and the Pareto criterion would not be met.31Voluntary associations (clubs) represent an intermediate option between a government with sovereignpowers and individual action. Neighborhood associations offer an example popular in some regions.

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levee? The social cost, the value of the resources being used in the construction ofthe levee, equals $20,000. The social benefit of the levee, the sum of the improvedwelfare of the individuals with the levee, equals $36,000. Because social benefitsare greater than social costs, it is a desirable project for the community.32 A respon-sive government would act to provide the levee and would raise sufficient fundsthrough the revenue structure to finance the project. If the government levied anequal per-capita tax—a payment based on the coercive power of government ratherthan the voluntary payment of market exchange—on the community to finance thelevee ($4,000 each), all individuals would still be better off with the levee and thetax than without the combination.33 Government can thus provide a desired servicethat public-good features prevent private action from providing.

A second example yields additional insights. Assume that the community re-ceives benefits from a project as shown in Table 1–2. The project, possibly a leveein another location, is a public good. The cost of the project is $20,000. Because thesum of individual benefits ($19,000) is less than the cost of the project, the projectresources would be worth more in other uses than in the particular use being con-sidered. Suppose, however, that the project decision will be made at a referendumamong the people in the community, with a simple majority required for passage.The referendum also includes the method to be used to finance the project: anequal per-capita tax (project cost divided by number of people in the community,or $4,000 per person). If the people in the community vote according to their indi-vidual net gain or loss from the project (as computed in Table 1–2), it will be ap-proved (three for, two against). Does voter approval make the project desirable forthe community? Not at all, because the project misallocates resources: It consumesresources that would have a greater value in other use. The majority vote may mis-allocate resources when used for public decisions, as may any technique that doesnot involve comparisons of social cost and social return.


Table 1–1Individual Benefits from the Project: Example 1

Individual Individual Benefit

A 8,000B 7,000C 6,000 Total cost � $20,000D 9,000E 6,000Total benefit $36,000

32A small number of people may construct the levee without the full coercion of government. For in-stance, individuals A, B, and D could form a small property-owners association; the sum of benefits tothose three exceeds the cost. These people might privately agree to build the levee for their protection—and benefits would spill over to C and E.33This tax “system” is selected for convenience alone. It is not a “model” or an “ideal” in any sense.

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A third example further illustrates the limits of scientific principles in public de-cision making. Table 1–3 presents individual benefits from a project with a totalcost of $12,500 and an equal per-capita tax method of distributing project costs.Total benefits do exceed total cost, so the project apparently represents an appro-priate way to use scarce resources, and the project would be approved by majorityvote if the people voted according to their individual gains or losses. The project,however, does leave one individual worse off. Is the loss to E less important to thecommunity than the gains of A, B, C, and D? That answer requires a value judg-ment about the worth of the individuals to society, a judgment with which scienceand Pareto cannot help. One option would be to distribute costs in exactly thesame proportion as individual benefits. That is the approach shown in the last col-umn of Table 1–3. Any project for which total benefits exceed total cost has possi-ble cost distributions from which all will be made better off. There is no redistribu-tion of individual cost from which all will be made better off for projects like thatdemonstrated in Table 1–2, but choices about situations like that shown in Table1–3 are difficult. Politicians make such decisions regularly, but not with scientificjustification.

One voting rule would ensure that only projects that pass the Pareto criterioncould be approved. That rule is unanimity, if we assume that people will not vote



Individual Individual Benefit Cost Share Individual Gain

A $5,000 $4,000 $1,000B 5,000 4,000 1,000C 2,000 4,000 �2,000D 1,000 4,000 �3,000E 6,000 4,000 2,000Total $19,000 $20,000


Individual Benefit-Share Based

Individual Cost Individual of Total CostIndividual Benefit Share Gain Benefits Share

A $3,000 $2,500 $ 500 15% $1,875B 5,000 2,500 2,500 25% 3,125C 8,000 2,500 5,500 40% 5,000D 3,000 2,500 500 15% 1,875E 1,000 2,500 �1,500 5% 625Total $20,000 $12,500 100% $12,500

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for policies contrary to their own best interest. This rule is seldom used, becausereaching decisions often requires substantial costs. James Buchanan and GordonTullock identify two elements constituting the full cost of making a communitydecision.34 The first element, the cost of reaching the decision, the “time andeffort . . . which is required to secure agreement,”35 rises as the agreement percent-age required for the decision rises. As more of the group must agree on any issue,the effort invested in bargaining, arguing, and discussion normally rises. That in-vestment is a real cost because the effort could have been directed to other uses.The second element, the external costs, or the cost from group “choices contrary tothe individual’s own interest,”36 falls as the agreement percentage rises. (These arethe costs imposed by a simple majority choice on individuals C and D in Table1–2. Those costs could have been prevented by requiring a higher vote for ap-proval.) The optimal choice percentage—the lowest combination of the two costelements—usually would require neither unanimity nor one-person rule becausethe former has excessive decision costs and the latter has excessive external costs.Certain decisions are more dangerous to minorities (the losers in decisions) thanothers. For instance, many juries must reach a unanimous verdict because of thevery high external costs that juries can place on people. For similar reasons, consti-tutional revision has high-percentage vote requirements.

Politics, Representation, and Government Finance

Decisions about public spending, raising revenue, borrowing, and so on are not theproduct of mechanical rationality. They are intensely political and involve personalinterests, interest groups, political parties, and the process of representation. Eventhe clearest preferences of any particular individual are usually filtered through rep-resentation, and that one preference becomes part of a vote that may or may not bein the majority whose choice prevails. The many elements that produce a fiscalchoice are diverse, but a framework devised by Anthony Downs for exploring theprocess of representation can help with an understanding of what influences thesedecisions.37 He hypothesizes that political parties in a democracy operate to obtainvotes to retain the income, power, and prestige that come with being in office. Par-ties are not units of principle or of ideals but are primarily seekers of votes. A lackof perfect knowledge, however, permeates the system: Parties do not always knowwhat citizens want; citizens do not always know what the government in poweror its opposition has done, is doing, or should be doing to try to serve citizen inter-ests. Information that would reduce this ignorance is expensive to acquire. Thescarcity of knowledge obscures the path that would lead from citizen preferencesto their votes. Neither political parties nor elected representatives know exactly


34James M. Buchanan and Gordon Tullock, The Calculus of Consent (Ann Arbor: University of MichiganPress, 1962), chaps. 6–8.35Ibid., 68.36Ibid., 64.37Anthony Downs, An Economic Theory of Democracy (New York: Harper & Row, 1956).

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what the voters want, and the voters do not know exactly what the government isup to.

Several consequences for the representative process result. First, some peopleare politically more important than others because they can influence governmentaction. Democratic government will not treat everyone with equal deference in aworld of imperfect knowledge. One person, one vote is the ideal slogan, but itdoesn’t represent political influence particularly well. Second, specialists in in-fluencing people will appear, and some will emerge as representatives of the peo-ple. These individuals will try to convince the government that the policies theysupport, and that directly benefit them, are good for and desired by the electorate.Information provided by these individuals will be filtered to provide only data consistent with the supported cause. A rational government will discount theseclaims, but it cannot ignore them. Third, imperfect information makes a govern-ment party susceptible to bribery simply because the party in power needs resources to persuade voters to keep it in power. Parties out of power are suscepti-ble as well, but they have less to sell. It is no accident that corruption scandals in-volve more Republicans when the Republicans are in power and more Democratswhen the Democrats are in power. Political influence is a necessary result of imper-fect information combined with the unequal distribution of income and wealth insociety. Parties have to use economic resources to provide and obtain information.

Lobbying is a rational response to the lack of perfect information, but an im-portant imbalance of interests influences the lobbying process. Suppose a directsubsidy to industry is being considered. This subsidy is of great total value to thatindustry. The total subsidy paid by taxpayers, of course, exactly equals the subsidyreceived by the industry. However, each taxpayer bears only a small individualshare of that total subsidy. Who will undertake the expense of lobbying on themeasure? The industry will, not the taxpayer, because the net benefit of lobbying ispositive for the industry (comparing the substantial cost of lobbying with the sub-stantial direct benefit to the industry) and negative for any taxpayer (because thesubstantial lobbying cost overwhelms the small individual share of the subsidy thatcould be saved).

These efforts to influence fiscal decisions take two general forms. Traditionallobbying is personal: “Affable men in suits would hang around swarming, sweatylegislative chambers, buttonholing lawmakers as they swaggered through lustrousbronzed doors, whispering in ears, slapping backs, winking knowingly.”38 The lob-byists know the elected representative and have access to them (usually becausethey can be counted on for contributions and other campaign assistance), know theunelected administrators carrying out public policies, and use these contacts to de-liver the message of their clients on issues. Many former legislators and agency ad-ministrators—federal and state—develop lucrative careers as lobbyists, using con-tacts and friendships to help deliver the message of the interests they represent;


38Ron Faucheux, “The Grassroots Explosion,” Campaigns and Elections (December 1994–January 1995).Lobbying state legislators can be crass: “It’s one of the accepted rules in the unwritten guide to being alobbyist. The way to get a lawmaker’s ear is to get him a drink first.” (Christi Parsons and Rick Pearson,“Springfield Has a Gift for Grab,” Chicago Tribune, 6 July 1997.)

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their value is in their access to the people who remain in government. In one recentexample, the member of Congress primarily responsible for the Medicare Prescrip-tion Drug Improvement and Modernization Act of 2003 (P.L.108173), an act thatprovided significant new revenue for the pharmaceutical industry and avoided priceconstraints on prescription medicines, left Congress for a position as chief lobbyistfor brand-name drug companies.39 Many call this easy mobility between legislativeor executive positions and interested private entities “a revolving door,” and fewbelieve it to be contributory to fiscal decisions in the public interest. But it is part ofthe way in which public policies get adopted today.

Grassroots lobbying is the mobilization of constituent action, reflected in let-ters, phone calls, e-mails, faxes, and other direct contacts to the elected representa-tive. Mass campaigns had great successes in getting civil-rights legislation and inshaping other policies, but communications and information technologies make itmuch easier to generate what appears to be a groundswell of interest and masses ofconstituent communications of public policy questions, including those of govern-ment expenditure and taxation.

A related influence on representative government is the principle of rational ig-norance. Citizen effort to acquire information to cast an informed vote is usually irrational.40 Although the cost of obtaining information may be low, the expectedreturn from an informed vote is even lower. If others vote in an informed manner, acitizen’s uninformed vote is irrelevant because the informed majority choice wins.If others vote in an uninformed manner, a citizen’s informed vote is irrelevant be-cause the choice of the uninformed majority wins. In either case, the action of themajority produces the election result, so individual effort to become informedyields no return. Thus, electorate choices produce indivisible benefits or costs. In-formation gathering to cast informed votes produces no electoral benefits for an individual. That, of course, is a crucial problem in any democratic society. Fortu-nately, many individuals become informed for other motives, including pure enjoy-ment. The power of the vote is an important reason why free, high-quality primaryand secondary education is so critical for democratic government.

A final important point in the process of representation deals with the intensityof preference. In ordinary voting, there are no methods of representing intensity ofpreference on particular issues. Each vote has equal weight. In a legislative body,however, the flow of many issues allows legislators to trade a vote on a minor issue(according to that person’s preferences) for a vote on a more important one. Trad-ing votes allows adjustments according to intensity of preference. For example, amember of Congress may be particularly interested in the outcome on issue B, buthave little concern about issue A. That representative may trade his or her vote onissue A for some other representative’s vote on issue B. This process, calledlogrolling, can produce wasteful spending (an irrigation project yielding benefit to a


39As Robert L. Livingston, former head of the House Appropriations Committee who became presidentof a lobbying firm, said about lobbying: “There’s an unlimited business out there for us.” (Jeffrey H. Birnbaum, “The Road to Riches is Called K Street,” Washington Post 22 June 2005: A1.) K Street in Washington is where the offices of the major lobbyists are located.40Downs, Chapter 18.

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small area at great national cost, for instance), but it can also improve the respon-siveness of government by ensuring that intense preferences get recognized. Fur-thermore, the representative process has special devices for protecting the interestsof minorities. These do not appear in the general referendum process of choice bydirect vote:

The required majority of those voting (in a referendum) can inflict severe cost on therest of society with dramatic consequences for the social fabric. Their major disadvan-tage must emerge from the absence of minority power in the direct legislation system.An initiated referendum has no provision for executive veto, creation of political stale-mates in the legislative process, or changed negotiating positions in committees, all vitalpositions of lawmaking which can serve to protect minorities.41

The Layers of Government

In the United States three layers of governments with sovereignty of their own (nota single government) provide public services, levy taxes, and borrow money. In-deed, there are more than 86,000 governments in the United States, counting fed-eral, state, and local entities. Not all nations are governed in this fashion. Some gov-ernments are unitary, meaning that a single national government has legislativeauthority over the entire country. There may be local councils with certain powers,but they function only on the approval of the national government. In many uni-tary states, local revenue and expenditure programs must be approved by the na-tional government, and a single consolidated financial program (or budget) existsfor the entire country. Unitary states include Belgium, France, the Netherlands,Norway, Poland, and many countries of the former Soviet Union (but not Russia).The United Kingdom, historically unitary, is devolving some powers to regionalparliaments in Scotland and Wales. Other nations are federal: Subnational govern-ments have considerable autonomous authority to make decisions, including diffi-cult decisions about taxing and spending. In no sense are these subnational units adependent department of the central government, as they may be in a unitary state.In the United States, states exist as an independent layer of government with fullpowers (including independent financial authority) and all residual powers.42 Otherimportant federal states include Argentina, Australia, Austria, Brazil, Canada, Germany, India, Mexico, and the Russian Federation (although recent changesthere to reduce sovereign powers of regional and local governments and movethem to the national government have moved the nation closer to being a unitarystate). In each instance, to understand government finances—spending, taxing, andborrowing—one must understand the intergovernmental structure in the country.


41John L. Mikesell, “The Season of the Tax Revolt,” in Fiscal Retrenchment and Urban Policy, ed. John P.Blair and David Nachimaias (Newbury Park, Calif.: Sage, 1979), 128.42The national government under the Articles of Confederation, precursor to the Constitution, lackedthe power to tax. Payments from the states proved inadequate, so it is no wonder that it resorted to fi-nance by printing money, which proved to be disastrously inflationary.

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In the U.S. federal system, constitutional terms define the elemental financialpowers and limits under which the levels function. First, there are powers and lim-its to national (federal) authority: Article I, Section 8, lists fiscally significant pow-ers. These include the powers

To lay and collect taxes, duties, imposts and excises, to pay the debts and provide forthe common defense and general welfare of the United States; but all duties, impostsand excises shall be uniform throughout the United States.

To borrow money on the credit of the United States.

To regulate commerce with foreign nations, and among the several States, and with theIndian tribes.

To coin money, regulate the value thereof, and of foreign coin, and fix the standard ofweights and measures.

To establish post-offices and post-roads.

To raise and support armies, but no appropriation of money to that use shall be for alonger term than two years.

To provide and maintain a navy.

Article I, Section 9, establishes some fiscal constraints:

No capitation, or other direct, tax shall be laid, unless in proportion to the census ofenumeration herein before directed to be taken.

No tax or duty shall be laid on articles exported from any State.

No money shall be drawn from the Treasury, but in consequence of appropriationsmade by law; and a regular statement and account of the receipts and expenditures of allpublic money shall be published from time to time.

Of course, legislation and court decisions have, over the years, specifically de-fined what these powers and constraints mean in practice.

The Constitution similarly identifies, in Article I, Section 10, powers specificallydenied the states. Of fiscal significance is the prohibition against coining money. Thecommerce clause (Article I, Section 8, paragraph 3, listed above) prevents state inter-ference with international commerce and commerce among the states, a particularlysignificant limit on taxing power and regulatory authority in a global economy. Thisis referred to as the Commerce Clause, and it plays an important role in many facetsof state taxation. A later amendment (Article XIV, Section 1) requires states to followdue process in their actions and to afford equal protection of the law to all withintheir jurisdictions. These provisions have had substantial impact on service provi-sion in the states, as courts have reminded state and local governments that fiscalprocesses must meet federal constitutional tests.43 The federal equal-protection


43Two examples: Public schools, as examined in Rosemary O’Leary and Charles R. Wise, “Public Man-agers, Judges, and Legislators: Redefining the ‘New Partnership,’” Public Administration Review 51 (July/Au-gust 1991): 316–27; and jails, as examined in Jeffrey D. Straussman and Kurt Thurmaier, “BudgetingRights: The Case of Jail Litigation,” Public Budgeting & Finance (Summer 1989): 30–42.

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clause has been often copied in state constitutions. The dramatic change in school fi-nance in California generated by the court case Serrano v. Priest44 resulted from stateconstitutional provisions copied after those in the federal law.

The major constitutional provision for states appears in the tenth amendmentof the Constitution: “The powers not delegated to the United States by the Consti-tution, nor prohibited by it to the States, are reserved to the States respectively, orto the people.” The states thus have residual powers. The Constitution does not needto provide specific authority for a state government to have a particular power: Con-stitutional silence implies that the state can act in the area in question, thus estab-lishing states as the sovereign “middle layer” in the federal system.

Local governments in the United States typically appear as captive creatures oftheir states, unless state action has specifically altered that relationship. This princi-ple was defined by Judge J. F. Dillon of Iowa:

It is a general and undisputed proposition of law that a municipal corporation possessesand can exercise the following powers and no others: First, those granted in expresswords; second, those necessarily or fairly implied in or incident to the powers expresslygranted; third, those essential to the declared objects and purposes of the corporation—not simply convenient, but indispensable. Any fair, reasonable, substantive doubt con-cerning the existence of power is resolved by the courts against the corporation, and thepower denied.45

Dillon’s rule thus holds that if state law is silent about a particular local power,the presumption is that the local level lacks power. In state-local relationships, stategovernment holds all powers. That is a critical limitation on local government fiscalactivity.

Several states have altered Dillon’s rule by granting home-rule charter powers toparticular local governments. Such powers are particularly prevalent in states con-taining a small group of large metropolitan areas with conditions substantially differ-ent from the environment in other areas of the state. The special conditions of suchlarge cities can be handled by providing them home-rule charter power to governtheir own affairs. State law can thus proceed without being cluttered by numerousspecial enactments for the larger units. When charter powers have been provided,local governments can act in all areas unless state law specifically prohibits those ac-tions. Many times, however, fiscal activities are included in the range of areas thatare prohibited under charter powers. Thus, it is better to presume limits than topresume local freedom to choose in fiscal affairs. That presumption is accurate ifDillon’s rule applies or if charter powers have been constrained in fiscal activities.

Conclusion

An overview of the basis for government action certainly indicates that governmentchoices made in budgeting and revenue raising will not be simple. Government will


44Cal. 3d 584, 487 P. 2d 1241, 97 California Reporter 601 (1971).45John F. Dillon, Commentaries on the Law of Municipal Corporations, 5th ed. (Boston: Little, Brown, 1911);vol. 1, sec. 237. See City of Clinton v. Cedar Rapids and Missouri Railroad Company (1868).

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be unable to sell its services because these services are nonappropriable (neither ex-cludable nor exhaustible). That means that government will not have normal mar-ket tests available to help it with choices.

Governments surely do not want to waste resources—after all, resources arescarce, and most things used by government do have alternative uses—so the bene-fits to society from government action ought to exceed the cost to society from thataction. Determining whether actions really improve the conditions of the commu-nity gets complicated, however, when there is no basis for making comparison ofthe worth of individuals. The Pareto criterion for the welfare of a community doesnot require interpersonal judgments, but it leaves many choices open to politicaldecision. Despite sophistication and rigor, science and analysis will not provide de-finitive answers to many government choices. Votes, either on issues or for repre-sentatives, will settle many decisions. Direct votes, however, will neither guaranteeno wasteful public decisions nor choices that satisfy the Pareto criterion for improv-ing society. They may well cause the imposition of substantial costs on minorities.Some problems of direct choice are reduced when representatives make decisions,but there will remain imbalances of influence and posturing to continue in officerather than to follow clearly defined principles. Lobbying—direct or grassroots—isone way in which some interests obtain extra influence.

Finance in a representative democracy is not simple. Governments should bejudged on their responsiveness to public preferences and on their refusal to ignoreminority positions. Not all governments can meet those simple standards, and not allbudget systems used in the United States do much to contribute to those objectives.The U.S. structure delivers and finances services using three tiers of government—federal, state, and local. Although independent in some respects, there are importantmutual constraints. The federal level has powers delimited in the Constitution; thestates have residual powers. Local governments—under Dillon’s rule—have onlypowers expressly granted by their states. Some states grant local home rule, givinglocalities all powers save those expressly prohibited. Few home-rule authorizationsare complete, however. Thus, budget and finance functions vary widely across thecountry.

QUESTIONS AND EXERCISES

1. A community project (a public good) will cost $2,500 and will benefit the fivemembers of the community as follows:

Resident Individual Benefit ($) Cost Share ($)

A 800 500B 800 500C 300 500D 350 500E 450 500


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a. Is the project economically feasible?b. Would the project be approved by a majority at a referendum?c. Does the project meet the Pareto criterion?d. If possible, revise the cost shares to allow the project to meet the Pareto cri-

terion and to pass a referendum.

2. Determine for your state the budget and finance constraints that the state placeson local government. Does Dillon’s rule apply? Do some units have home-rulepowers? What is the extent of any such powers?

3. Private businesses have a great interest in quality primary and secondary educa-tion because today’s students are tomorrow’s employees. However, privatebusinesses make limited financial contributions to this sector of education (ex-cluding the taxes they pay to public school systems), even to market-orientedprograms like vouchers and charter schools. What do you suppose explains thislow contribution level? (Hint: consider what sort of good primary and sec-ondary education might be.)

CASE FOR DISCUSSION

CASE 1–1

Market Interplay, Municipal Utilities, and a Common-Pool ResourceGovernments often are surprised by private responses to what appear to be rela-tively straightforward and sensible public decisions. It should be no surprise thatbusinesses respond to higher prices for their purchases by trying to economize ontheir use of those more expensive resources. What may be surprising is how thesereactions themselves create even more complex problems for the government. Inthe case described here, the normal business response is particularly interesting be-cause it crosses between the operation of a municipal utility and the exploitation ofa common-pool resource. Here is a case from The Wall Street Journal.

Consider These Questions

1. Identify the various types of goods (private, public, and in between) involved inthis case. What was the primary objective being sought and how was it being fi-nanced? Is that financing approach appropriate for the type of good involved?

2. What options might governments in the Boston area have?

3. What would you recommend to prevent further damage?


SOURCE: Wall Street Journal, (20 January 1993), B-1. Reprinted by permission of the Wall Street Journal, © 1993Dow Jones & Company, Inc. All rights reserved worldwide.

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City Dwellers Drill for Precious Fluid1

As water rates go up, some Bostonians are going down—about 900 feet to findwater. Average water and sewer bills in Boston have more than tripled since1985 to cover costs of cleaning up Boston harbor. To cut their bills, severalBoston businesses have recently drilled their own wells.

“It’s a very alarming trend,” says Jonathan Kaledin, executive director ofthe National Water Education Council, a Boston-based group that tracks water-project funding issues. As customers “leave the system,” those who remainmust shoulder higher funding burdens.

If such drilling becomes a trend, it could undermine funding in a number ofcities for projects to comply with clean-water laws. New York City water pro-jects, for example, are expected to cost more than $10 billion during the 1990s,according to a recent report by Mr. Kaledin’s group.

Boston officials also worry that buildings in the city’s Back Bay area, a fill-in swamp, may sink if wells lower the water table. Structures there rest on im-mersed wooden pilings that “will rot in two or three years” if exposed to air as the water level drops, warns Boston City Councilman David Scondras. City officials, citing over 400 known hazardous-spill sites in Boston, also fret thatwells may tap into polluted water.

But the economic arguments for drilling are overwhelming, says RogerBerkowitz, co-owner of Legal Sea Foods, a Boston restaurant chain that re-cently drilled a well. Its 15,000 gallon-a-day gusher saves the company $2,500 amonth by providing water for laundry and other uses. Though it isn’t used fordrinking, Mr. Berkowitz says, tests show water from the chain’s well surpassesBoston’s municipal water in purity.


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Fundamental Principles of Public Finance - BrainMass1.pdfCHAPTER 1 Fundamental Principles of Public Finance Why study public ﬁnancial administration separately from business ﬁnance?